Gold and silver streamers offer a conservative way to invest in metals

An aerial view of Vale’s Salobo copper mine, the largest copper deposit ever discovered in Brazil. Wheaton Precious Metals Corp. is a major partner in the mine and receives 75 per cent of the gold produced from it.

Salviano Machado/Vale

DIANNE MALEY

Special to The Globe and Mail

Published February 27, 2018Updated April 23, 2018

A geological engineer by trade, Randy Smallwood is spending most of his time these days explaining to potential investors why Wheaton Precious Metals Corp. stock is such a good buy.

Wheaton is a pure precious metals play with predictable costs, exploration upside and a diverse asset base, Mr. Smallwood points out. Wheaton pays a dividend, it is leveraged to gold and silver prices and – oh yes – it's cheap, or as the company says, it has a "compelling valuation."

Mr. Smallwood is president and chief executive officer of Wheaton, a Vancouver-based silver and gold streaming company formerly known as Silver Wheaton that was spun out of Goldcorp Inc. in 2008.

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Persuasive as his argument may be, it's been a tough sell because investors hate uncertainty. Simply put, Wheaton Precious Metals's stock has been beaten down relative to its peers because of its dispute with the Canada Revenue Agency over streaming income from mines in other countries.

The CRA takes the position that income earned by Wheaton's foreign subsidiaries from mines located outside Canada should be taxable in Canada. Wheaton argues that income earned by its foreign subsidiaries from mines outside Canada should not be subject to Canadian tax. The dispute is in discovery, and a trial date is expected to be set in the next couple of months before the Tax Court of Canada.

The market seems to be favouring Canada's other two big streaming companies, the storied Franco-Nevada Corp., founded by Seymour Schulich and Pierre Lassonde in 1983, and Royal Gold Inc.

In its investor presentation, Wheaton looks at three valuation measures: price to net asset value, price to earnings and price to operating cash flow. It takes the multiples Franco-Nevada and Royal Gold enjoy and applies them to its own market capitalization to come up with an implied value. Based on an average of the three measures, Mr. Smallwood figures his company should be worth US$5-billion more than it is. Wheaton's market capitalization is US$9.7-billion. Wheaton reports its financial results in U.S. dollars.

Let's take a step back and look at what these companies do and why they are appealing. Royalty and streaming companies provide much-needed financing to mining companies, especially in early stages and when metal prices are down and money is hard to get. This type of financing does not dilute the equity of existing shareholders or weigh down the miners' balance sheets with debt. While Franco-Nevada originally was a royalty company, streaming has emerged as the model of choice.

"We're all streaming companies now," Mr. Smallwood says. He describes streaming as a contractual relationship between two partners to work together for the betterment of the project. Rather than a royalty cheque, streamers get gold and silver, which they sell. Put another way, the streamer makes an upfront payment to the mine operating company, and in return gets a fixed percentage of the future silver or gold production from a mine at a predetermined price.

Historically, mine operators have not been known to enrich their shareholders. Streaming companies, for the most part, have.

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In a research report titled Streamers, the Low-risk Gold Investment, Joe Turner, an analyst at Pring Turner Investment Management, lays out the case for streamers plainly. Streamers offer a conservative way to invest in precious metals for five powerful reasons, Mr. Turner writes.

– They are not subject to operational risks that miners face such as rising costs, or labour or equipment problems. They simply share in the revenue of the mine.

– The largest streaming companies have seasoned management teams who have the experience needed to choose the strongest partners and best projects.

– Streaming agreements are attached to the land or the metals, not the operator. So if the operator changes or goes bankrupt, the agreement still stands.

– "Optionality" or upside potential. A mine may start out small but through further exploration can become a bonanza for the streamer as payments increase over time.

– Broad diversification because the companies have royalties or streams over dozens or even hundreds of projects in different countries.

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Wheaton's troubles date back to 2012, when the CRA launched an audit of its books. At the time, Wheaton was trading at a premium to Royal and Franco-Nevada. "The marketplace took it badly," Mr. Smallwood recalls. "We gradually lost value and we've been battling it ever since."

So far, the CRA is seeking taxes, interest and penalties of $353.4-million for 2005 to 2010, a number that could rise substantially if it takes the same approach to subsequent tax years. Years 2011 through to 2013 would add another $310-million. Altogether, Mr. Smallwood says, Wheaton could be facing a bill of $1.4-billion to the end of 2017 if the CRA prevails. How the case is resolved has "broad implications, not just for the streaming companies but for other mining companies, and perhaps any company with international operations," Mr. Smallwood says.

Is the beating the stock has suffered overdone? Is Wheaton Precious Metals a buy?

Analysts seem to think so. Of eight analysts surveyed at press time, five have a strong buy rating on Wheaton stock and three a moderate buy, according to the Globe Investor website. The information is provided by Zacks Investment Research. By comparison, seven analyst ratings for Franco Nevada show one strong buy, one moderate buy, four holds and one strong sell.

In a recent research report, analyst Tony Lesiak of Canaccord Genuity affirmed his "buy" rating on Wheaton stock. The increase was partly because of a restructured streaming deal on the San Dimas mine in Mexico and partly because the CRA dispute could be resolved before too long.

"We no longer believe it is suitable to assume the worst-case scenario [for Wheaton] in our valuation," Mr. Lesiak writes in the report. His damage estimate includes the discounted cash flow effect of future taxation on the company's foreign income.

In the end, it may be the allure of gold and silver that will draw people to precious metal streaming companies and hold them there. Big tax cuts in the United States bode ill for the U.S. dollar, Mr. Smallwood says.

"The U.S. government is spending more than it takes in. The only way it can manage is to print more money and devalue the currency. In an environment where the U.S. currency is weakening, people will look to hard assets like gold and silver as a store of value."

Spirit of 'Old Franco' lives on

Under Seymour Schulich and Pierre Lassonde, Franco-Nevada Corp. first applied the oil and gas royalty model to gold miners in 1983. It was hugely profitable. Up to the time Franco-Nevada merged with Newmont Mining Corp. in 2002, it had returned gains of more than 30 per cent a year to shareholders year in and year out. That's because it started out small and grew to become one of the leading royalty companies in the world.

In 2007, Newmont decided to spin Franco-Nevada off again in a public offering. Market cap continued to grow. Now that it's so much larger, can management hope to match the historic returns of what it calls the "Old Franco?"

"When we went public again in 2007, we didn't know if we could match anything like that," Paul Brink, senior vice-president, business development at Franco-Nevada, said. The performance so far has been impressive. "We're just past our 10th anniversary and our compound average return has been 20 per cent a year."

In its new iteration, Franco-Nevada has expanded into oil and gas and, to a lesser degree, base metal streaming. Still, 90 per cent of its revenue is tied to precious metal prices, Mr. Brink says.

He's not troubled by a sell rating on Franco-Nevada's stock. "Franco has always traded at a good valuation," Mr. Brink says. "We have some analysts who take the view that you should sell the best-valued stock in the sector and buy the cheapest one. So far, that strategy hasn't worked out."

As to where Franco shares might fit into investors' portfolios, he sees them as an alternative to the gold-backed (GLD) exchange-traded fund. Gold serves as a hedge against inflation or the decline of the U.S. dollar.

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